Home Equity: Credit Drought Withering Specialty Finance Firms

The global market turmoil has disrupted what had been an extremely productive relationship between real estate finance specialists and Wall Street investment houses.

In recent weeks, risk-wary investment banks have suddenly pulled credit lines from specialty finance companies, stopping growth in its tracks and throwing several firms into bankruptcy.

In one case, a real estate investment trust, Criimi Mae Inc., filed for bankruptcy protection last month and sued three of its lenders.

The sudden collapse in the flow of Wall Street money suggests a vulnerability in the new paradigm of real estate finance, which relies on securitization and leveraged financing, rather than generating hard cash, for growth. Often when markets go south, a herd mentality can take hold, prompting lenders to bail out, even though companies were doing fine otherwise, observers say.

"You never want to be the last one at a party," said Michael McMahon, analyst with Sandler O'Neill & Partners. Lenders that pull out of deals try to do so quietly, he said, because "you don't want the other lenders to wake up."

Specialty lenders grew at double- and triple-digit rates in the last few years, fueled by securitization, which allowed them to make more and more loans.

To win mandates to underwrite securitization deals, investment banks aggressively offered up warehouse lines where the lenders could stash loans before securitizing, or lines of credit backed by the residual securities retained by the companies. This accelerated the companies' growth.

Many subprime lenders would develop relationships with several investment banks, playing them off one another to get the best terms.

"This was just wonderful" for these companies, Mr. McMahon said, because they had never been given access to such financing before.

Before securitization, many specialty lenders sold loans individually to private investors. The ability to sell off large portfolios at once, combined with easy financing, "was like the fountain of youth," Mr. McMahon said.

The problem has not been confined to the residential market. Margin calls forced Criimi Mae, a real estate investment trust and commercial mortgage conduit, into bankruptcy, leading to litigation.

Criimi Mae, based in Washington, invested in the riskier, lower-rated pieces of commercial mortgage-backed securities offerings. It was a crucial player in that market; some have estimated that it bought half the subordinated bonds that came to market.

It financed these purchases with credit lines from investment banks, some of which were underwriters of commercial mortgage-backeds. In late August, international market turmoil sent commercial mortgage bond prices tumbling. Criimi's holdings were hit hardest.

In early October, Merrill Lynch & Co. made a margin call, claiming that the $558 million of securities Criimi was using to back its $274 million loan had lost so much value that the loan no longer had adequate security.

Criimi said it had been meeting previous collateral calls. However, it could not meet Merrill's, which it said was based on appraisals that were very different from the valuations behind the earlier calls. On Oct. 5, the company filed for bankruptcy protection.

Shortly afterward, Criimi filed lawsuits against Merrill, Citicorp Securities, and Morgan Stanley Dean Witter. It asserted that Merrill was wrongfully withholding interest payments on its bonds and that the other two lenders' attempts to seize collateral violated the U.S. bankruptcy code.

The suits hold wider implications.

"It's very important that lenders in those situations be able to exercise remedies that the code provides them, to close out and liquidate positions they may have with a defaulting or bankrupt or insolvent counterparty," said George P. Miller, deputy general counsel for the Bond Market Association.

The code's "automatic stay" bars secured creditors from seizing assets of borrowers who have filed for bankruptcy. But it exempts repurchase agreements, or repos.

In the cases against Morgan Stanley and Merrill, Criimi is also disputing the lenders' valuations of the securities, which are sharply different from its own appraisals.

The loan pools underlying these bonds have performed quite well, showing no unusual losses and delinquencies. The market for subordinated commercial mortgage-backeds, however, had a limited universe of buyers, and the liquidity crisis only made the market value of the bonds more subjective.

"When you get into a severe credit crunch, valuation is not a technical issue anymore," said Michael Ervolini, chief executive officer of Charter Research, a Boston analytical firm. "It's literally dangling it out the window and seeing what price you get. The fact that very reasonable and authoritative groups can come up with vastly different valuations is not surprising at all."

In a court filing, Merrill said the market for subordinated commercial mortgage-backeds "has become, during the last 90 days, ever more volatile and illiquid." Between July and October, Merrill said, the market value of the securities fell more than 12%.

William B. Dockser, Criimi Mae's chairman, contended that Merrill's appraisal was arbitrary and not based on objective information. "You just cannot decide, 'We're moving the mark 200 or 300 basis points because we think there's a tightness or illiquidity in some faraway part of the globe,'" he said.

A Morgan Stanley spokeswoman would only say that Criimi's suit against it was "without merit" and that the firm would defend itself "vigorously."

But those in Wall Street's camp said that Criimi was off the mark.

"It's not that subjective," said a bond trader at one of the top commercial mortgage-backed underwriters, who did not want to be identified. "There's a variance between dealers, but it's not as huge as the variance between all dealers versus Criimi Mae."

Some of the specialty finance companies made a big mistake, analysts say, by not having a backup plan and by failing to seek permanent financing.

Even companies that have secured so-called committed warehouse lines are not necessarily protected, said E. Reilly Tierney, analyst with Fox-Pitt, Kelton in New York.

Most of these lines have a clause that allows lenders to withdraw them if market conditions change, he said. This clause, known as a MAC, or material adverse change clause, "undermines the committed nature of the line," Mr. Tierney said.

Criimi Mae had an exit strategy. It pooled some of its illiquid holdings and securitized them in transactions called "re-Remics." Jim Callahan, executive director of Pentalpha Group, Greenwich, Conn., said, "They realized Wall Street were a fickle bunch of people."

Criimi was planning to issue its third re-Remic in 1999 and used its credit lines to finance the securities while it aggregated them on its balance sheet. Unfortunately for the company, it "got caught on the day they were waiting to do one of those deals," Mr. Callahan said.